Industry professionals discuss trends around climate change-related risks and how captives can be implemented to help address these risks as they evolve in frequency and severity
Described by the World Economic Forum in its 2021 Global Risks Report as an “existential threat to humanity”, climate change consistently ranks conspicuously high as a risk of concern within the insurance industry, in terms of both likelihood and impact.
The report, produced in partnership with Marsh McLennan, SK Group and Zurich Insurance Group, identifies the top three highest risks of the next decade, according to likelihood, to be extreme weather, climate action failure and human-led environmental damage, respectively. Other named environmental risks include major natural disasters, water crises, and failure of climate change mitigation and adaptation.
In particular, climate action failure is named the most impactful risk and the second most likely long-term risk in the report’s Global Risks Perception Survey — meaning that the global transition to a greener economy cannot be delayed until after the effects of the COVID-19 pandemic abate.
The frequency and severity of climate change is the ‘new normal’ in meteorological, hydrological and geophysical terms, with corresponding issues ranging greenhouse gas emissions, atmospheric carbon dioxide concentration, global surface temperatures, global mean sea level, and the frequency of extreme weather events.
With climate change comes two main economic risks: physical risks and transition risks. Physical risks are caused by event-driven or long-term shifts in climate patterns, which have the ability to cause both direct damage to tangible assets and indirect damage to production and supply chain through business interruption. Transition risks are associated with the shift to a low-carbon economy, whereby investments could lose value and cause a macroeconomic supply shock.
The themed report, ‘Working together to tackle climate risks: risk professionals and the insurance industry’, released by the Association of Insurance and Risk Managers in Industry and Commerce (Airmic) and KPMG, highlights that transition risks are beginning to attract a higher level of attention.
Furthermore, in the association’s annual survey, Airmic identifies the number one issue of concern for risk professionals to be regulatory compliance in the context of ESG principles, with climate change as a key area for insurers and buyers to work more collaboratively.
The annual survey also reveals that 43.8 per cent of risk professionals believe that climate change will have a material impact on their organisations within one or two years, particularly in the energy, utilities, food, beverage, banking and finance sectors.
Extreme events in recent years that demonstrate the already tangible impact of anthropogenic climate change include heatwaves in Western North America, extreme rainfall in Western Japan and Central Europe, bushfires in Australia, and Hurricanes Harvey and Maria in North America.
Despite these palpable examples, a recent report by S&P Global Ratings finds that reinsurers may be underestimating their exposure to natural catastrophe risk by as much as 50 per cent. An empirical stress scenario based on 30 years of insured loss experience finds that 70 per cent of events in the last 20 years have been made worse or more likely by climate change.
S&P also determines that 2021 marked the second-largest amount of insured catastrophe losses on record, while secondary perils have contributed a record-high amount to total insured losses.
Alex Pui, head of natural catastrophe and sustainability, Asia Pacific (APAC), Swiss Re, explains: “In insurance industry parlance, ‘secondary perils’ actually has two meanings; it refers to non-peak perils (such as earthquakes or tropical cyclones) as well as typically more frequent losses, such as floods, flash floods, hailstorms, convective storms and wildfires.”
A separate report by Aon recapping global catastrophes in the first half of 2021 estimates total economic losses from natural disasters at around US$93 billion, while insured losses stand at around $42 billion, marking a 2 per cent increase from the 10-year average.
“We are seeing an increasing burden in these losses that actually rivals some of the losses from the peak perils themselves,” Pui notes.
“This is definitely a very obvious trend that we have seen, which is also consistent with the increasing frequency of these particular events. There is a divergence between total economic losses and insured losses; a gap which is growing and causing less resilience in the financial world in general.”
Pui highlights that this is particularly true of the APAC region for two reasons. As a high economic growth region with increasing economic density, this increases loss potential. Secondly, climate risk strikes disproportionately in the region, with rising sea levels causing typhoon activity in the Philippines and in the Pearl River Delta region in Hong Kong.
Under the weather? Consider a captive
With the increasing frequency and severity of extreme climate-related events and environmental impairment liability, it is of paramount importance for companies to consider their risk management frameworks and how the alternative risk transfer market can be of benefit. In particular, firms must be more nuanced in their understanding of how climate change can and will impact their businesses, and how to manage this risk.
“With more intense, severe weather events, it is clear that our climate situation is rapidly evolving at a pace that necessitates accounting in risk pricing today,” explains Sean Rider, chief revenue officer at One Concern.
“As a result, we are finally seeing different financial services and insurance firms realising that they are not prepared to price risk with today’s models. As rising climate-related losses threaten insurers, the industry is looking to partner more with artificial intelligence companies like One Concern to understand their climate risks at the property level, which previously was not possible.”
The flexibility of a captive means it is well suited to facilitate such understanding and provide coverage solutions for emerging or evolving risks that are unquantified, difficult to price and lack risk data — or else simply lack adequate coverage in the commercial insurance market.
“In this context, captives are typically used to warehouse acute climate perils that are often deemed too difficult or too expensive to place in the traditional insurance market. If an individual business unit were to go out and procure insurance by itself, this would not be an efficient way to obtain capital,” Pui explains.
Rider adds that captives are able to better absorb new and innovative analytics techniques that directly link climate change to current and future risks compared to traditional insurance structures.
“Captives are freer to pilot and test newer technologies and innovations that enable them to quickly and accurately address their climate-related risks. As a result, they are more resilient and better equipped to withstand and bounce back from climate impacts,” he says.
Many captives already insure risks relating to traditional property weather perils, or a form of standalone weather-sensitive coverage, particularly in the agriculture and transportation industries.
Captive coverage should include contingent business interruption, as this forms an essential part of the exposure to first-party physical and non-physical damage business interruption losses.
Another advantage of captives, according to Pui, is the ability to establish a track record: “Although these risks are very difficult to place today, if a captive is managed well and is able to demonstrate a track record of loss history, it could then be positioned to eventually actually transfer some more of that risk into the open market.”
Reassessment of the dynamics of property catastrophe supply and demand has placed greater importance on reinsurance markets — to which captives offer access — particularly in terms of pricing adequacy, risk profiles, and risk selection.
As well as using captives as part of an organisation’s overall risk management strategy to mitigate the financial impact of extreme weather events, parametric insurance can be used to pay out an aggregate amount in the event of a specific trigger.
For example, in August parametric insurance provider Arbol launched a solution for climate change risk management, Captive+Parametric, which allows companies to take immediate action in their risk management by transferring climate risks into captives through a parametric structure. The participating companies have access to Arbol’s climate data, intelligence platform, and online structuring and pricing tools.
In addition, Howden Group collaborated with Replexus and the Danish Red Cross to implement a Guernsey-based insurance-linked securities (ILS) structure to create a world-first humanitarian catastrophe bond covering pure volcanic eruption.
No time for a rain check
This article has noted that it is critical for a company to integrate climate risk into its broader risk management framework for emerging risks — but how can an organisation best position itself to do so?
Airmic and KPMG’s climate risk report emphasises the need for collaboration between corporate risk managers and reinsurers during the transition to net-zero. Reinsurers are expected to assume a greater role in mitigating the effects of climate change, building resilience to its impacts, and supporting the transition to a low-carbon economy as they can augment their existing knowledge of physical risk to adopt an enterprise-wide approach.
This is particularly important as climate risk is strongly linked to enterprise risk. Consequently, companies must develop climate risk scenarios, stress test exposed assets and develop a climate strategy for liabilities.
Pui comments: “For any organisation, there should be a realisation that climate risk is an inherently complex topic rather than a tick box exercise. With that acknowledgement comes significant investment in terms of building up capability internally, to be in a position to understand what climate service providers and consultants are actually feeding them with.”
In its survey, S&P finds that reinsurers have increased their efforts to integrate climate change considerations into their decision-making processes, especially concerning risk management, exposure management and pricing. However, although 71 per cent of survey respondents indicate they consider climate change in their pricing assumptions, only 35 per cent say they include a specific allocation of price for climate change.
A physical climate risk assessment is a complex operation that nevertheless must be undertaken for a company to understand the limitations and quantifying uncertainties of climate models, according to Pui, who describes global climate models as “the latest crystal balls that enable a view into the future”.
Therefore, a firm must incorporate this model uncertainty into a holistic view of climate risk that considers beyond modelled outputs, encompassing literature, catastrophe modelling and interdependencies between events.
Climate and catastrophe models can help to project future risk profiles, as the results can be used for asset value estimation, stakeholder management, strategy reevaluation, and to meet regulatory disclosure requirements.
“By incorporating climate change scenarios into analytics, organisations can do a better job at benchmarking mitigation actions,” adds Rider. He notes that the ever-changing nature of technologies and innovations enables highly strategic resilience investments that are informed by data-supported insights.
“With the aid of new technologies and capabilities, such as One Concern’s digital twin platform, organisations can run stress and reverse-stress testing scenarios to identify previously overlooked vulnerabilities that have not posed a direct threat until recently,” Rider continues.
“The key component here is disclosure. The more companies disclose about their climate-related risks, the more insight is added to the reservoir of knowledge that will price climate risks more accurately while supporting a green economy.”
There is a distinct opinion among respondents in Airmic’s annual survey that they view regulations and reporting requirements, such as the Task Force on Climate-Related Financial Disclosures (TCFD), as an opportunity to enhance their focus on ESG issues relevant to the resiliency of their business. From this regulatory perspective, for reporting periods beginning on or after 1 January 2021, the UK Financial Conduct Authority mandates all premium-listed companies to state in their annual financial reports whether their climate-related financial disclosures are in-line with the recommendations of TCFD.
39.9 per cent of respondents in the Airmic-KPMG survey state they are ready for such disclosure, while 33.6 per cent say they are actively working to be ready.
However, as many as 17 per cent of respondents cite they have not yet taken quantification and management actions on climate — these are more likely to be in the public and non-for-profit sectors.
Pui adds: “With respect to TCFD and regulation, this is important, but only if set up in the right way to incentivise more disclosure from companies by levelling the playing field. At this point in time, TCFD is still voluntary but remains the closest to an international best practice or standard that we currently have.”
“However, the landscape is fast changing, with individual regulators already signalling that they will start to make climate reporting mandatory. It is best to be in a position to be ready for that change, and to make sure that good change management is in place,” he adds.
It never rains but it pours
As a unique risk that, unlike most other types of risk, cannot be controlled or financed when necessary, there are challenges associated with the use of captives to insure against climate risk.
From a data and analytical perspective, non-traditional weather risks pose issues as many companies do not keep internal records of specific weather risks, or their impact on revenue or tangible assets. Without this information, it is difficult to establish a preliminary trigger in coverage.
Rider adds: “Since captives tend to be much more related to the business that created them, they may overlook aspects of how climate change affects society on a larger scale, which can have meaningful downstream impacts. With this, factors related to energy, for example, might be overrepresented in one group, whereas a traditional reinsurer will look more broadly across hazard risks.”
Furthermore, as climate risk management becomes more and more complex, companies face greater ambiguity and uncertainty over the appropriate investment balance between loss prevention and loss mitigation.
Pui notes: “It sounds obvious, but ultimately the captive itself is effectively still self-insuring climate risk, so it is not able to transfer it out anywhere else. This becomes a unique issue with respect to climate risk, because a lot of these large companies have operations in different parts of the world and are therefore vulnerable to the supply chain problem.”
He adds that effective diversification may be difficult if the base rate rises in too many different regions: “If the intention is to use the captive to place risk in the ILS markets, then the pricing and market education will also be key challenges.”
“Coverage will not be cheap just because you have a captive — although you will have greater access to different risk pools, this does not mean that those different potential risk transfer partners will react any differently to traditional insurance markets,” Pui continues.
In addition, challenges arise as companies with frameworks that rely on historical data to construct output assumptions may struggle to implement catastrophe models. Therefore, it is crucial for firms to invest in new dynamic technologies.
However, there are still significant uncertainties in climate models, as they are first and foremost designed to examine how the global climate system would react to the conditions and consequences of climate change, rather than to assess physical risk. It is also important to note that such models should be used to inform, as opposed to dictate, decision-making processes.
“From the perspective of addressing climate change, the most significant challenge in using captives is that they might not have the full range of capabilities to carry out the type and degree of analysis that best suits their needs,” Rider states.
He continues that this can be addressed by captives partnering with the broader vendor community that possesses the tools, technology and experience necessary in order to better understand the exposure to climate change risks faced by a company and wider society.
Into the eye of the storm
Such partnerships between captives and emerging companies are likely to be explored in more detail in the future, Rider anticipates, adding that the industry is still in the phase of trying to model risk more effectively and understand how climate change is driving risks at a granular level.
Looking forward to the evolution of climate change coverage, Pui expects “cautious attempts” to test new solutions for property and catastrophe, since this remains the largest and more direct market for climate risk. New solutions include coverage such as parametric hail, flood or wildfire.
He identifies another key emerging area of note as carbon offset insurance. This is an example of “enabling insurance solutions rather than mitigating” (enabling meaning it will insure renewables or the construction of more renewable energy sources). Another example includes directors and officers liability, as the impact of anthropogenic climate change becomes increasingly clear.
“In the next 12 months, I do not think there will be any large movements in the climate risk space, as it has to be incremental. While insurance can be seen as the only panacea to climate risk, it must be mitigated by actions on the ground, such as whole infrastructure protective assets,” Pui concludes.
